Page 243 - AFM Integrated Workbook STUDENT S18-J19

Hedging interest rate risk

Question 4

Orange Co is in the process of arranging a four-year $60 million loan.

The interest rate on the loan will be a fixed annual rate of 3% or an annual
floating rate of base rate plus 0.2%.

The finance director has suggested that the company will be able to lock into
an attractive fixed rate of interest by entering into an interest rate swap contract
with a counterparty, where the counterparty can borrow at an annual floating
rate of base rate plus 1.4% or at an annual fixed rate of 3.8%. The bank would
charge a fee of 10 basis points each to act as the intermediary of the swap.

Required:

Calculate the effective interest rate for Orange Co and the counterparty,
assuming that any savings from the swap are split equally.

Solution

Orange Co has a comparative advantage on floating rates (saving 1.2% versus
the counterparty compared with only 0.8% on fixed rates). Therefore if Orange
Co initially borrows at a floating rate, leaving the counterparty to borrow at a
fixed rate, the net saving (before fees) will be 1.2% - 0.8% = 0.4%.

If we split this equally between the two parties, each should ultimately benefit
by 0.2%:

Payments Orange Co Counterparty (CP)

To lender (Base + 0.2%) (3.8%)

Orange to CP (2.6%) 2.6%

CP to Orange Base (Base)

Net (2.8%) (Base + 1.2%)

After taking account of the fees (10 basis points or 0.10% each), Orange Co
will pay a total of 2.9%, and the counterparty will pay (base rate + 1.3%).

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